Bonds: We Are in a Brave New World

Given recent actions, the way we view fixed income may be changed forever.

Just as Christopher Columbus sailed to explore the vast undiscovered world, undaunted by early geographers' interpretation that the world was flat and they could fall off, so, too, are bond traders now anxious about where the new world order leaves them. This following the Fed's historic helicopter money bailout and quantitative easing, "QEternity."

For the time being, we seem to be rejoicing as the Fed and Treasury announce trillions and trillions of dollars to throw at the U.S. economy to help salvage the economic and financial damage. However, the question I keep getting asked is, "How much is enough?" or "Is this it?"

As monstrous as the pace of the market falloff has been, so, too, has the buying by the Fed. Just this past week, they have bought about $622 billion in Treasury and Mortgage Backed Securities (MBS), amounting to 2.9% of U.S. GDP in one week! To put that in perspective, that was the entire size of round 2 of QE. Their balance sheet has ballooned to $5.25 trillion, an approximate $1 trillion increase in just two weeks.

To top that off, the Senate just passed a $2 trillion fiscal bill, including $250 billion for private individuals, $350 billion for small business loans, $250 billion in unemployment insurance benefits, and $500 billion in loans to distressed companies. The latter is the one up for debate as there seem to be no details or guidelines as to who qualifies for that and whether they should even get the assistance.

Companies such as Boeing (BA) that used profits to buy back shares to boost earnings and made questionable company decisions now deserve the right to be saved? How are cruise line companies a vital part of the economy, or "too big to fail?" It now seems rather than make a choice between Lehman Brothers and Merrill Lynch or AIG, today the mantra is "save them all". It is just helicopter money.

Every week the Fed just announces more and more QE to buy up risky assets if the market keeps falling. Next step, actual equity ETFs?

The latest move inspired some sense of support for the market as the Fed included municipal bonds and corporate bonds to the list of instruments they could buy through a Special Purpose Vehicle that bypasses a change in legislation. Thanks to their latest maneuverer this week, we have seen a 13% rally in investment-grade corporate bonds (iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) ), and a 10% rally in high yield bonds (iShares iBoxx $ High Yield Corporate Bond ETF (HYG) ), the areas of the bond market most at risk of serious liquidation following the corporate bubble burst.

How is it a free market when prices are not allowed to fall to their "fair value" is a debate for another time, as the Fed has been on this path for the past decade.

Unprecedented amounts of debt will need to be issued by the Treasury to help pay for all this stimulus and open-ended QE. With most foreign banks now turned sellers of Treasuries, one wonders who will be the buyer of all this U.S. debt?

The simple answer is the U.S. Fed. Their balance sheet can easily hit $6 trillion by next week and, who knows, perhaps even $10 trillion in a month's time ( I mean these are just 0's after all, right?). The next obvious question is who guarantees that the U.S. government does not default? Judging by the sovereign credit default swaps, that is not as remote a possibility as was thought a little while ago.

The way we view bonds may be changed forever, as they no longer constitute being a "safe asset" or a portfolio hedge as has been advised for the past decade. The 60-40 Risk Parity model most advisors have been leveraging off will no longer work if bonds are not a true market, but one rigged by the U.S. Fed artificially controlling the yield curve.

It seems we are following in the footsteps of Bank of Japan. One would think history would teach us a lesson about that course of action. Fixed-income markets, for now, will no longer give us the same "read through" or signals as before, as long as the entire market is monetized by the Fed.

We are re-writing Modern Portfolio Theory as we speak. All this paper being issued, not only in the U.S., but in the rest of the world, will cause a hyper-inflationary shock that can only mean one thing: own hard physical assets such as gold, silver, and, if you are brave enough, bitcoin. Fiat currency as we know it will continue to be debased and worth less than the toilet paper we have stored at home judging by the rate the Fed is printing dollars. The next few years in an environment such as this, bonds will no longer be seen as a hedge, but could fall as inflation shoots higher.

As for the equity markets, the S&P 500 has had a vicious rally this week from the 2180 lows as we managed to touch the 2600 level, the 38.2% Fibonacci retracement. The volume has been light, and, as seen by the hedge fund books, they seem to have been de-leveraging rather than adding as VAR is still quite high. Futures open interest has not increased, so the participation in this rally has been low. Some commentators, those who have never seen a bear market in their working lives, are suggesting a bottom is in place.

The longer the U.S. economy and rest of the world is in lockdown, the more the stress and losses in the system, the harder it will be to bounce back. Most people expect a V-shaped recovery following the end of lockdowns. Thursday, the U.S. economy showed an increase of 3.2 million jobless claims.

This week was saved by the extra $850 billion of month-end window dressing by pension funds that needed to re-allocate funds away from bonds and into equities. The rate of new cases has not peaked in the U.S., or the world. Perhaps that is the best indicator, if any at all, before we can even talk of a bottom being in place for the markets.

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At the time of publication, Bengali had no positions in any securities mentioned.

The historic April jobs report provides clues on what to expect from here.

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